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February 17, 2012

Truth Talking on Taxes: Don’t Believe Everything You Hear

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There’s an old saying (based on Scripture) that affirms “the truth will set you free.” Yet I often wonder if our government officials ever heard the saying because, year after year, we seem to hear more evidence pointing to the contrary. For instance, many politicians appear to twist the truth during campaign years as it relates to our tax code in an effort to manipulate voters into believing what they want them to hear instead of the actual truth. Maybe that really isn’t the case; perhaps our politicians are just inadequately educated about the comprehensive truth as it relates to taxes.

The one area in this regard that really pushes my buttons is the barrage on the wealthy and capital gains tax versus ordinary income tax. Regardless of party or political alliances, we always see the same attacks on the rich relative to taxes. The usual portrayals seem to insinuate that the rich have somehow found the so-called “Holy Grail” of tax loopholes, allowing them to create an enormous gold mine of wealth for themselves. From that viewpoint, everyone in America seems to become jealous of their success, regardless of the work involved in actually obtaining wealth in the first place. Have we as a country come to expect a Utopian society where no one has to do anything, but should be entitled to everything?

For example, the present attacks on Mitt Romney’s individual taxes are very similar to what I’m referring to. An article entitled: “Mitt Romney’s Taxes and True Reform,” written by Mike Brownfield for The Heritage Foundation, explains why very few Americans can ever completely understand the truth about our tax code. As such, I hope I can shed some light on one aspect of the code through a simple illustration below.

Let’s assume you started a C Corporation business in 2000 that has grown into a major publicly traded company (of which you still own 50% of the outstanding stock), with excess of $500 million in gross revenues. Assuming net income of $300 million before taxes and dividend distributions, taxed at a maximum rate of 35%, the company would owe $105 million in corporate federal income taxes, with another 5% at least in state tax, or $15 million. Let’s further assume the corporation issued a dividend at the end of prior year to shareholders totaling $50 million. Of that, you’re entitled to 50% of the dividends, or $25 million ($50 million x 50%), on which you’ll have to pay 15% federal tax or $3.75 million, and at least 5% state tax or $1.25 million.

The moral of the story is this: as 50% owner of the corporation, you would have paid an estimated $52.5 million in federal corporate taxes, $7.5 million in state corporate taxes, $3.75 million in individual federal dividend taxes, and finally $1.25 million in state individual income taxes (assuming a 5% rate), totaling $65 million!

When comparing your 50% ownership right to the corporation’s net profits, it could

be argued that your gross taxable income is really $150 million ($300 million x 50%). If you then pro rata allocate the total tax paid across both corporate and individual taxes to your 50% income right of $150 million, we see that you would have paid an effective tax rate of 43.33% ($65 million ÷ $150 million).

That surely is not the 13% or 15% effective tax rate that the news media or politicians portray for this wealth owner in my example. For some reason, they overlook the prior tax paid on the dividends or capital gains from the corporate tax level, before reaching the individual level, resulting in a distortion of the truth, especially if compared to mainstream Americans’ income tax structure.

Our politicians seem to continually use the tax code as a manipulative tool in order to confuse the truth on taxes in order to be elected. But don’t believe everything you hear, because when it’s all said and done, the government is getting 86% of its tax money from only 25% of its citizens, as noted in my article, Wealth and Taxes on AdvisorOne in October 2010. It’s also ridiculous that our corporate tax structure is one of the highest in the world, which I addressed in my April 2011 AdvisorOne article called Continuous Robbery.

Why can’t we just make taxes simple for everyone to understand? How much money do our government and politicians really need? Or is it really all about controlling our money so we can’t ever control them? Don’t let the verbal barrage on the wealthy by politicians manipulate you into believing that 25% of America is made up of billionaires and millionaires, because that would be the biggest twist of the truth ever. As earlier noted, “the tax truth will set you free,” regardless of your level of income, because only lower taxes across the board are going to help this economy.